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Net budget cost of Treasury proposal

September 26, 2008

A Wall Street Journal blog posting mischaracterizes CBO's testimony earlier this week on the net budget impact of the Treasury proposal to buy troubled assets. The Wall Street Journal blog states that the plan "likely won't have any effect on the 2009 budget deficit." That is incorrect.

Here's what I said in the testimony:

"In particular, the federal budget would not record the gross cash outlays associated with purchases of troubled assets but, instead, would reflect the estimated net cost to the government of such purchases (broadly speaking, the purchase cost minus the expected value of any estimated future earnings from holding those assets and the proceeds from the eventual sale of them). In CBOs view, that budgetary treatment best reflects the impact of the purchases of financial assets on the federal governments underlying financial condition. The fundamental idea is that if the government buys a security at the going market price, it has exchanged cash for another asset rather than caused a deterioration in its underlying fiscal position."

The testimony then noted that even though the gross cash outlays would perhaps amount to $700 billion, the net budget impact would be substantially smaller because the government would be acquiring assets with some value. It did not say, though, that the net budget impact would be zero, as the Wall Street Journal suggests.

So what will the net budget impact be, even if it's substantially smaller than $700 billion? That depends on three factors: (a) the degree to which the transactions result in a gain or loss to the government; (b) the administrative costs of running the program; and (c) any interactive effects with other government programs. The first issue is central, and the testimony noted that "whether those transactions ultimately resulted in a gain or loss to the government would depend on the types of assets purchased, how they were acquired and managed, and when and under what terms they were sold."

The testimony went on to explore the forces that could affect any gain or loss. "In addition to the future evolution of the housing prices, interest rates, and other fundamental drivers of asset values, two key forces would influence the net gain or loss on the assets purchased:

Whether the federal government seeks and is able to succeed in obtaining a fair market price for the assets it purchases and, in particular, whether it can avoid being saddled with the worst credit risks without the purchase price reflecting those risks. Concerns about the governments overpaying are particularly salient when sellers offer assets with varying underlying characteristics that are complicated to evaluate. Such problems are attenuated the more that the government focuses on buying part of a given asset from institutions that all own a share of that asset, rather than buying different assets from different institutions. That is, the government is more likely to pay a fair price when multiple institutions are competing to sell identical assets than when it has to assess competing offers for different assets with hard-to-determine values.

Whether, because of severe market turmoil, market prices are currently lower than the underlying value of the assets. If current prices reflect fire sale prices that can result from severe liquidity constraints and the impairment of credit flows, then taxpayers could possibly benefit along with the institutions selling the assets. Under normal circumstances, prices do not long depart from their fundamentals because the incentive to engage in arbitrage and profit from price discrepancies is large. But arbitrage practices work less well when liquidity is restrained, as it is now, and many potential arbitragers cannot get short-term financing. It is therefore at least possible that the prices of some assets are below their fundamental value; in that case, to the extent that the government bought now and held such assets until their market prices recovered to reflect that underlying value, net gains would be possible."

Nothing in CBO's testimony should be interpreted as suggesting that the interplay between these two forces would generate a net impact of zero for the transactions alone. Indeed, although the lack of specificity in the bill means that CBO cannot currently quantify its net budgetary impact, and although there is some possibility that the government could realize a net gain on the transactions authorized under the bill, it seems more likely that enacting the bill would result in an increase in the federal deficit. In other words, the net budgetary cost (including administrative costs) is very likely to be substantially smaller than $700 billion, but it seems likely to be greater than zero.